R.G. Barry Corporation (NASDAQ: DFZ), based out of Pickerington, Ohio, is a developer and manufacturer of accessory footwear, including slippers, sandals, slippery socks, hosiery, hybrid and active fashion footwear, some of which is developed and sourced as private label footwear for some of North America’s leading retailers. Their products are predominantly sold in North America (company’s primary source of both revenues and cash flows) through department stores, chain stores and mass merchandising channels of distribution.
The company was founded in 1947, and operated a manufacturing-based business model for 57 years; in 2004, they implemented their current business model, which doesn’t involve the operation of any manufacturing facilities (all products sourced from overseas, along with R&D being relocated there in 2010). As noted in the 10-K, “Under our current model, we have recorded consistent profitability and increased net sales annually since 2005, a period that has included some of the most difficult retail seasons in decades.”
The company’s fiscal year ends in late June, which was changed in 2006 to simplify planning and financial reporting due to the fact that approximately 70% of their revenues are derived in the last six months of the year (holiday shopping). The company has noted that one of their corporate objectives is to acquire or to develop businesses that will add more seasonal balance to the annual business cycle (as you will see, this is why R.G. Barry is a value at $11 per share). Since 2006, in an effort to diversify from their core slipper business, the company has moved into sandals and fashion footwear, along with handbags and travel accessories, many of which are sold in retail channels not previously served by the company.
The chief executive officer of R.G. Barry is Greg A. Tunney, who has held this position since May 2006. Since taking the helm at R.G. Barry, the company has had impressive operating results, with revenues, net earnings, and diluted EPS increasing at a rate of 6.16%, 17.9%, and 16% per annum, respectively. Prior to joining the company in early 2006, Mr. Tunney was the president and COO of Phoenix Footwear Group, a supplier of diversified apparel (including footwear, belts and sportswear) for seven years. The remainder of the executive team has widespread experience in the apparel industry, including former leadership positions at Limited Brands (LTD), Oakley, and New Balance.
Compensation is a good check of whether management is benefiting with you or in spite of you. Unfortunately for R.G. Barry, the executive team, and especially Mr. Tunney, appears to be overpaid. In 2010, for example, his total compensation exceeded $1.6 million, or more than 10% of pretax earnings; while this isn’t significant in absolute terms (compared to eight-figure salaries at Fortune 500 companies), it is substantial in relative terms. In addition, Mr. Tunney only held 42,529 shares at the time of the filing, or roughly 30% of his annual compensation (based on current share price). While he has done a great job in the past five years at R.G. Barry, it would be more convincing if he put a larger portion of his net worth along side shareholders.
R.G. Barry operates a sourcing office in Dongguan City, China, where the company purchases slipper-type products from fourteen different third-party manufacturers (all of whom are located in China). One product (Superga, which is a licensed) is sourced from third-party Vietnam-based suppliers who provide those same products to Superga’s parent company, BasicNet.
After third-party transportation delivers the products to the United States, the company has two distribution routes. The first is an independent third-party logistics provider located in southern California, which stores products, fulfills orders and distributes R.G. Barry’s products to customers. The second route is a leased distribution center in San Angelo, Texas, which primarily supports shipments of Terrasoles and Superga (two brands) and other replenishment, closeout product and e-commerce orders (case pack shipments to customers). Among these facilities, only the corporate headquarters is owned; the other properties are leased, with an approximate aggregate annual rent of $565,500.
As of April 2, the company had a strong balance sheet, with more than $63.5 million in current assets, compared to roughly $57 million in total liabilities (working capital ratio of 4.8:1). At this point last year, the balance sheet was even stronger, with more than $40 million in cash and equivalents; the reason this account has dried up is due to the acquisitions of Foot Petals, LLC and Baggallini, Inc. business operations (combined cost of $47 million after assumption of debt is accounted for); more on this later. As a result of recent business developments, cash flow in the near future (a good portion; I estimate at least 50%) will be spent on debt repayment (roughly $4 million per year through 2016) and regular dividend payments ($0.07/quarterly at the time of writing, suggesting a $3 million annual cost).
During fiscal year 2010, the company increased sales by nearly 9% (compared with 2009), or $10 million, to $124 million. Pre-tax earnings were $15 million, equal to a pretax profit margin of 12.1%. For the year, net earnings (after tax) of $9.4 million were equal to diluted EPS of $0.85, an increase of more than 30% from 2009 EPS of $0.65. A historical 10-year review of the company would be misleading, because the change in business model has essentially created an entirely new entity; luckily for us, the past 5-6 years (since the change) has included both an economic boom and bust, which should provide us with an accurate view of the company’s operations through the business cycle. In the past five years (2005-2010), diluted EPS has jumped between $0.45 and $0.92 with an average in the range of $0.75-$0.80/share (2007 must be adjusted (reported EPS of $2.46) for tax benefit of $13.6 million due to the reversal of a deferred tax asset valuation allowance).
YEAR TO DATE RESULTS
The company reported third quarter earnings (ended April 2) this week, which provides us with up-to-date information for our analysis. Throughout the first nine months of the year, sales are essentially flat ($107 million versus $106 million), while net earnings are down 24% over the same time period (without adjusting for acquisition costs in the third quarter of this year). The biggest weakness in the quarter was footwear, which swung from a third-quarter operating profit of $718,000 in 2010 to a third quarter loss of $965,000 in 2011. This was largely driven by lower volumes (also the driver of a 9.4% overall sales decline in the quarter) to mass merchandisers and warehouse clubs, along with higher product costs paid to third party manufacturers. As noted on the call by the CFO, “The decline reflected the impact of not repeating a spring promotional footwear program this year in the warehouse club channel, and reflected also fewer shipments of replenishment slippers to our largest customer.”
Obviously, this is concerning since footwear is a key part of the business; are we talking about a short term slip, or is this a red flag to investors? Here is what Mr. Tunney had to say on the call: “In the replenishment business, we are right in the middle of a process of shifting our replenishment businesses that we have in place and what happens is every year to two years you have a replenishment business that needs to be refreshed, that needs to be brought in and we are right in the cycle of doing that. For those who have followed R.G. Barry in years past, there was a time when we did a switch-off with a couple of our different retailers and this is one of those seasons where we’re doing it. So I would tell you from a softness in the business, no, I don’t see that.”
As outlined above, the company has generated earnings power of $0.75-$.80 per diluted share (consistently around 10-11 million shares outstanding, but slowly increasing due to stock based compensation) since the new business model has been implemented. At the current price (time of writing, $11.48 per share), this suggests a P/E multiple of 14.3x-15.3x earnings; not a screaming buy. However, as mentioned above, the company spent nearly $50 million (as a reminder, we’re talking about a company with a market cap of $127 million) on the acquisitions of the Foot Petals LLC and Baggallini Inc. business operations; what adjustment should we make to account for their impact on the income statement?
FOOT PETALS, LLC
Foot Petals LLC, a Long Beach, Calif.-based developer and marketer of premium insoles and products for common footwear-related problems, was purchased in January of this year for $14 million in cash. At the time, R.G. Barry CEO Greg Tunney called the acquisition “a key element of R.G. Barry’s long-term growth strategy.” In addition, as discussed by CFO Jose Ibarra at the time of the deal, Foot Petal’s is cash flow positive, and would be immediately accretive to earnings.
On March 31, R.G. Barry acquired Oregon based handbag and travel accessory maker Baggallini Inc. for $33.8 million (also cash). While the company is private, some data was released at the time of purchase; for example, the company achieved an annual sales growth rate in revenues of 16% since 2006. Mr. Tunney had this to say at the time: "These additions will transform our business and our future… The face of R.G. Barry immediately changes from that of a one-dimensional, modest-growth slipper company to that of a multi-faceted, growing provider of functional, fashionable accessories.” One important note on both acquisitions: They have significant goodwill components. For example, with Baggallini, the company recorded goodwill of approximately $28 million; this should be deductible for tax purposes.
The question is what is the quantitative affect of this “transformation?” Here is what can be found in the 10-Q; for Foot Petals, “Net sales and net earnings were not significant in respect of the Company’s condensed consolidated statement of operations for the Nine-month reporting period ended April 2, 2011. Any proforma net sales and net earnings of the combined entity, were likewise not significant to any combined view of proforma Company condensed consolidated statements of operations for the nine-month periods.”
With Baggallini, the story is a bit different: while sales and earnings were not included in the nine month numbers, proforma sales would have been nearly $120 million (with net earnings above $11 million), compared to actual results of $106 million and $8.4 million for revenues and earnings, respectively. The same is true for proforma results through the first nine months of 2010, with sales and earnings increasing by $11 million and $2 million, respectively; clearly, Baggallini will have a material impact on R.G. Barry’s results once they are consolidated.
Why is this transformation so important? A look at the third quarter breakdown by segment operations can help explain why. Despite more than $17 million in footwear sales in third quarter 2011, the company reported an operating loss of nearly $1 million. Accessories (which is simply the two acquired businesses), on the other hand, had only $2.4 million in sales, yet reported $815,000 in operating profit; not only does this segment balance out the seasonal nature of the footwear operations (gift-oriented slipper products), but it can also drive sales and cash flow in the quarters that footwear lags. With $30 million in net sales (historical) between the two businesses and targeted net growth of 10% looking ahead, these are material additions to R.G. Barry, and will cause revenues and net income to pop in the coming years.
On the company’s conference call from Wednesday, May 11, management dug deeper into the acquisitions and what they mean for R.G. Barry:
“The additive nature of new businesses should increase consolidated revenue for fiscal 2012 to around $140 million. Consolidated gross profit, which has traditionally been targeted around 40% of net sales, is modeled to rise to around the mid-40s. We will achieve this by restoring our footwear gross profit to around its traditional level, and then layering on the much richer margins from our new accessories segment. Consolidated operating profit is expected to increase from our traditional range of 10-12% of net sales to the mid-teens.” To clarify, this forecast accounts for businesses that management is currently exiting, which have annual revenues of $10-12 million; a back of the envelope calculation shows 2010 revenue ($123) – divestitures ($12) + acquisitions (historical $30) is already at $140 million, assuming now growth. If management can even put up these numbers (the $140 figure), we’re looking at operating profit in excess of $20 million per annum, compared to a range of $10-14 million over the past couple of years.
My two biggest concerns would be the “dirty bomb” type risks, the first of which is the nature of production and the supply chain. From the 10-K: “Our overall experience with third-party manufacturers has been very good in terms of reliability, delivery times and product quality. All of our purchases in China are conducted on an open account basis. We recognize, however, that reliance on third-party manufacturers does carry elements of risk. During fiscal 2010, we did not experience any substantial adverse quality or delivery issues. We will continue to ensure that the sourcing activities supported by our Dongguan office are effectively aligned to ensure that the quality and delivery of products complies with our and our customers’ standards. We are dependent on methods of third-party transport to move our products from our third-party manufacturers to our distribution facilities, and from those facilities to our customers.” An important side note is that the company has a section in the 10-K which discusses their dedication to ethical business operations; they, along with key customers, conduct human rights and supplier audits, and “demand the highest business and personal ethical standards.”
Another issue is dependence upon a few large customers, as noted in the 10-K: “Walmart Stores Inc. and its affiliates accounted for 35%, 38% and 37% of our consolidated net sales during fiscal 2010, fiscal 2009 and fiscal 2008, respectively. Our sales to Walmart Stores Inc. (WMT) and its affiliates are less seasonal in nature than those to many of our other customers. J.C. Penney Company Inc. (JCP) accounted for 10%, 10% and 11% of our consolidated net sales during fiscal 2010, fiscal 2009 and fiscal 2008, respectively.” Obviously, the loss of any of these key customers would have a material effect on the business; however, the fact that they have done business with these two companies for a substantial period of time (mentioned in 2000 10-K) should suggest some stability in the relationship.
The value proposition is as such: The company has consistently earned (on average) $0.75-$0.80 in diluted EPS since 2005. In this quarter, Foot Petals and Baggallini delivered nearly $1 million in operating profit; on an annualized basis, there is no reason to believe that this division can’t deliver $2-3 million in additional profit to R.G. Barry’s bottom line; despite the tax benefits from goodwill, let’s assume they pay a full 35% on those profits, good for an after tax benefit of $1.3-$1.95 million (based on conservative measure assuming no growth and no tax benefits). When we take that on a per share basis (based on 11 million currently outstanding diluted shares), we get an additional $0.12-$0.18 per share in EPS, moving our range for earnings power closer to $0.90-$1; essentially, you can buy R.G. Barry, which has current assets worth more than total liabilities, for 11-13x our conservative estimate of earnings power in a tough retail environment and assuming no growth; when we look at the acquisitions discussed above, I believe that is a pessimistic and unrealistic expectation for the future. As noted by Mr. Tunney on the call, “we entered this year as a one-dimensional, modest growth slipper company; we will leave fiscal 2011 as a multi-dimensional growing provider of functional fashionable accessory products.” While you sit and wait for the changes to take hold in the business, R.G. Barry pays a dividend with a current yield of 2.44%; based upon these conclusions, I believe that R.G. Barry Corporation is a conservative value investment at less than $11.50 per share.